If you are a homeowner, investor, or real estate professional, then you have likely heard the term depreciation. It sounds like something that could happen to your car, but what does it really mean for investors and homeowners? Depreciation is an accounting technique businesses use to account for the loss in value of their assets over time. The same concept applies to residential and commercial properties as well. Fortunately, one can claim capital allowances on investment property to reduce tax liabilities.
By why do properties depreciate in the first place?
1. Non-Income Generating
One of the primary reasons for an investment property’s lack of appreciation is it’s non-income generating. Like a vehicle, it will already lose some of its value as soon as you buy it. It doesn’t go up even if somebody is renting it.
For example, if you pay £500,000 for a house that rents out for £1,500 per week, it has already lost at least some of its value because it is not currently producing the income level required to maintain its purchase price.
2. Changes in the Market
Sometimes an investment property depreciates due to external factors. One of these is changes in the market. Gentrified areas, for instance, experience a significant increase in capital or investment appreciation. The neighborhood feels new, the place attracts a younger workforce or a more diverse population, inviting more businesses.
On the other hand, mass movements can leave certain areas at a disadvantage. The demand for properties may drop, which can prevent even some of the best houses from appreciating. Another possibility is that low-income families cluster to a specific area, limiting the growth of capital investments here.
3. Economic Obsolescence
A third reason that properties depreciate is because of what economists call “economic obsolescence.” This means that the property becomes less useful over time.
For example, many years ago, caravans were very popular. But today they are considered too small for modern needs so no one really wants to rent them anymore.
As a result, some caravan parks have closed down. Others have been redeveloped with apartments or other more valuable uses to keep their value better than before.
Also, technology such as laptops and mobile phones has evolved. People can now do much more work from home. It’s common to see vacant office space near major business districts due to redundant businesses closing down and moving elsewhere. This type of economic obsolescence causes commercial buildings and warehouses to depreciate.
4. Wear and Tear
Of course, properties can depreciate because of physical deterioration, which causes properties to be less useful than it did perhaps years or decades ago.
It doesn’t matter how good your house might look on the exterior or how well it is furnished throughout. If you have a 100-year old weatherboard home, then it’s very likely that you’ll need to spend some money on maintenance.
Similarly with industrial properties, many years ago, no one seemed to care about the quality of the surface on the roads outside their business. Most types of factory equipment were made from metal and therefore required little or no maintenance.
In many cases, the depreciation is a result of disinvestment from the owner. This includes neglecting their residence’s maintenance and upkeep, resulting in undesirable living conditions for residents that drive down demand.
For this reason, if you have no plans on moving and you don’t care how your property is maintained, depreciation may not be a significant concern of yours. However, if you plan to sell in the future, depreciation could be a problem that will cost you money.
This doesn’t mean that property values have no other way to go but down. It may increase because of inflation, population growth, and/or market conditions.
The appreciation could also result from the “investment” you made in upgrading and improving your home. You’ll see larger-than-expected increases if you’ve invested in updating the kitchen and bathrooms or added more living spaces or new landscaping with trees and flowers, paved a parking area, or built a deck off the back of the property.
Even better, you can use the expenses you incur to lower your tax liability provided that you spent the money on improving a business-related property.
Nevertheless, an investment property doesn’t exist without depreciation. You might as well use it to your advantage by claiming your capital allowances and then use the savings to maintain it, so you can at least keep the property value or prevent it from declining further.